READING NO.

50
FIXED-INCOME SECURITIES: DEFINING ELEMENTS

Disclaimer: Certain materials contained within this text are the copyright property of CFA
Institute. The following is the source for these materials: “CFA® Program Curriculum
Level I Volume 5, page no. 339 to 346”
READING NO. 50
FIXED-INCOME SECURITIES: DEFINING ELEMENTS
LOS 50.a: Describe basic features of a fixed-income security.
 The issuer of the bond.

 The maturity of the bond.

 The par value of the bond.
 The coupon rate offered on the bond and coupon payment frequency.
 The currency in which bond payments will be made to investors.

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Issuer includes:
 Sovereign (national) governments (e.g., the United States).
 Non-sovereign (local) governments (e.g., the state of Pennsylvania in the United States).
 Quasi-government entities, agencies owned or sponsored by governments (e.g., the postal
services in many countries).
 Companies or corporate issuers, which include financial issuers (e.g., banks) and nonfinancial
issuers (e.g., pharmaceuticals).
 Supranational organizations (e.g., the World Bank and the International Monetary Fund).

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A sovereign bond has a maturity of 15 years. The bond is best described as a:
A. perpetual bond.
B. pure discount bond.
C. capital market security.

C is correct. A capital market security has

an original maturity longer than one year.

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LOS 50.b: Describe content of a bond indenture.
LOS 50.c: Compare affirmative and negative covenants and identify examples of each.
<<credit enhancement>>

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The legal contract that describes the form of the bond, the obligations of the
issuer, and the rights of the bondholders can be best described as a bond’s:
A. covenant.
B. indenture.
C. debenture.

B is correct. The indenture, also referred to as trust deed, is the legal

contract that describes the form of the bond, the obligations of the issuer,
and the rights of the bondholders.

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An affirmative covenant is most likely to stipulate:
A. limits on the issuer’s leverage ratio.
B. how the proceeds of the bond issue will be used.
C. the maximum percentage of the issuer’s gross assets that can be sold.

B is correct. Affirmative (or positive) covenants enumerate what issuers are

required to do and are typically administrative in nature. A common affirmative
covenant describes what the issuer intends to do with the proceeds from the bond
issue.
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Which of the following best describes a negative bond covenant? The issuer
is:
A. required to pay taxes as they come due.
B. prohibited from investing in risky projects.
C. required to maintain its current lines of business.

B is correct. Prohibiting the issuer from investing in risky projects restricts the
issuer’s potential business decisions. These restrictions are referred to as
negative bond covenants.

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Clauses that specify the rights of the bondholders and any actions that the
issuer is obligated to perform or is prohibited from performing are:
A. covenants.
B. collaterals.
C. credit enhancements.

A is correct. Covenants specify the rights of the bondholders and any actions that
the issuer is obligated to perform or is prohibited from performing.

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Which of the following best describes a negative bond covenant? The
requirement to:
A. insure and maintain assets.
B. comply with all laws and regulations.
C. maintain a minimum interest coverage ratio.

C is correct. Negative covenants enumerate what issuers are prohibited from

doing. Restrictions on debt, including maintaining a minimum interest coverage
ratio or a maximum debt usage ratio, are typical examples of negative covenants.

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Relative to negative bond covenants, positive covenants are most likely:
A. legally enforceable.
B. cheaper for the issuers.
C. enacted at the time of the bond issue.

B is correct. Positive (or affirmative) covenants are typically administrative in

nature and do not impose additional costs on the issuer, whereas negative
covenants are frequently costly.

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LOS 50.d: Describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-
income securities.
 Domestic bonds trade in the issuer’s home country and currency. Foreign bonds are from foreign issuers
but denominated in the currency of the country where they trade.
 Eurobonds refer to bonds that are denominated in a currency other than the local currency where they are issued.
They may be issued in any country and in any currency (including the issuer's domestic currency) and are named
based on the currency in which they are denominated. For example, Eurobonds denominated in U.S. dollars are
referred to as Eurodollar bonds.
 An example of a Eurobond is a U.S. dollars-denominated bond issued by Toyota Motor Company in Australia.
This bond would be a Eurodollar bond (since it is denominated in U.S. dollars).
 Eurobonds are usually bearer bonds (i.e., no record of bond ownership is kept by the trustee). On the other hand,
domestic and foreign bonds are usually registered bonds (the trustee maintains a record of bond ownership).

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A South African company issues bonds denominated in pound sterling that
are sold to investors in the United Kingdom. These bonds can be best
described as:
A. Eurobonds.
B. global bonds.
C. foreign bonds.

C is correct. Bonds sold in a country and denominated in that country’s currency

by an entity from another country are referred to as foreign bonds.

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Relative to domestic and foreign bonds, Eurobonds are most likely to be:
A. bearer bonds.
B. registered bonds.
C. subject to greater regulation.

A is correct. Eurobonds are typically issued as bearer bonds, i.e., bonds for
which the trustee does not keep records of ownership. In contrast, domestic and
foreign bonds are typically registered bonds for which ownership is recorded by
either name or serial number.
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LOS 50.d: Describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-
income securities.
 Issuing entities may be a government or agency; a corporation, holding company, or subsidiary; or a
special purpose entity.
 The source of repayment for sovereign bonds is the country’s taxing authority. For non-sovereign
government bonds, the sources may be taxing authority or revenues from a project. Corporate bonds are
repaid with funds from the firm’s operations. Securitized bonds are repaid with cash flows from a pool of
financial assets.
 Bonds are secured if they are backed by specific collateral or unsecured if they represent an overall claim
against the issuer’s cash flows and assets.
 Interest income is typically taxed at the same rate as ordinary income, while gains or losses from selling a
bond are taxed at the capital gains tax rate. However, the increase in value toward par of original issue
discount bonds is considered interest income.

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An investor in a country with an original issue discount tax provision
purchases a 20-year zero-coupon bond at a deep discount to par value. The
investor plans to hold the bond until the maturity date. The investor will
most likely report:
A. a capital gain at maturity.
B. a tax deduction in the year the bond is purchased.
C. taxable income from the bond every year until maturity.
C is correct. The original issue discount tax provision requires the investor to
include a prorated portion of the original issue discount in his taxable income
every tax year until maturity. The original issue discount is equal to the
difference between the bond’s par value and its original issue price.
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Which type of bond most likely earns interest on an implied basis?
A. Floater
B. Conventional bond
C. Pure discount bond

C is correct. A zero-coupon, or pure discount, bond pays no interest; instead, it is

issued at a discount to par value and redeemed at par. As a result, the interest
earned is implied and equal to the difference between the par value and the
purchase price.
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LOS 50.d: Describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities.
 Internal credit enhancement focuses on the structure of the issue regarding priority of payment or the value of collateral.
 Subordination: This refers to the allocation of cash flows among the various bond classes or tranches based on their seniority.
Basically, the subordinate and junior tranches provide credit protection to the senior tranche, so in the event of default the senior
tranche (the one with the highest level of seniority) has the first claim on available cash flows, and only once senior bonds have
been paid off do subordinate bonds (and then junior bonds) get repaid. This type of protection is also referred to as a waterfall
structure—proceeds from liquidating assets are first allocated to the more senior tranches, while losses are allocated bottom-up
with the most senior tranche typically insulated from credit losses unless the total amount of loss exceeds the par amount of
subordinated and junior tranches combined.
 Overcollateralization: This occurs when the value of the collateral posted to secure an issue exceeds the par value of the securities
issued. The excess collateral can be used to absorb future losses. For example, a securitized issue with a total par value of $130
million would be overcollateralized by $20m if it is backed by $150 million worth of loans.
 Excess spread (or excess interest cash flow): A transaction can be structured in a manner such that the cash flows generated from
the collateral pool exceed the amount of interest payable to bondholders so that there is a cushion for making interest payments.
This excess amount is known as the excess spread, and it is sometimes deposited into a reserve account to protect against future
credit losses (by being used to retire principal). This process is known as turboing.

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LOS 50.d: Describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-
income securities.

 External credit enhancement refers to guarantees received from a third-party guarantor.

 Bank guarantee
 Surety bonds (issued by an insurance company): In the event of default, both these forms of enhancement
reimburse investors for losses (up to a prespecified maximum amount known as the penal sum).
 Letters of credit: These are lines of credit provided by a financial institution to the issuer to reimburse any
shortfalls in the cash flow generated from the collateral pool.

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Which of the following is a type of external credit enhancement?
A. Covenants
B. A surety bond
C. Overcollaterization

B is correct. A surety bond is an external credit enhancement, i.e., a guarantee

received from a third party. If the issuer defaults, the guarantor who provided the
surety bond will reimburse investors for any losses, usually up to a maximum
amount called the penal sum.
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LOS 50.e: Describe how cash flows of fixed-income securities are structured.
Bullet structure
Amortizing structure
 Partially amortizing structure
Sinking fund provision: Bond holder may incur loss when interest rates falls.
Floating-rate notes: cap, floor, inverse floater
Other coupon structures include step-up coupon notes, credit-linked coupon bonds,
payment-in-kind bonds, deferred coupon bonds, and
 index-linked bonds:
 Interest indexed bonds
 Capital indexed bonds - US Treasury Inflation Protected Securities (TIPS)

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A five-year bond has the following cash flows:
• Loan of $1,000, repaid in five installment of $230.97
The bond can best be described as a:
A. bullet bond.
B. fully amortized bond.
C. partially amortized bond.

B is correct. A bond that is fully amortized is characterized by a fixed periodic

payment schedule that reduces the bond’s outstanding principal amount to zero
by the maturity date. The stream of £230.97 payments reflects the cash flows of
a fully amortized bond with a coupon rate of 5% and annual interest payments.
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A bond that is characterized by a fixed periodic payment schedule that
reduces the bond’s outstanding principal amount to zero by the maturity date
is best described as a:
A. bullet bond.
B. plain vanilla bond.
C. fully amortized bond.

C is correct. A fully amortized bond calls for equal cash payments by the bond’s
issuer prior to maturity. Each fixed payment includes both an interest payment
component and a principal repayment component such that the bond’s
outstanding principal amount is reduced to zero by the maturity date.
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A company has issued a floating-rate note with a coupon rate equal to the
three-month Libor + 65 basis points. Interest payments are made quarterly
on 31 March, 30 June, 30 September, and 31 December. On 31 March and
30 June, the three-month Libor is 1.55% and 1.35%, respectively. The
coupon rate for the interest payment made on 30 June is:
A. 2.00%.
B. 2.10%.
C. 2.20%.
C is correct. The coupon rate that applies to the interest payment due on
30 June is based on the three-month Libor rate prevailing on 31 March.
Thus, the coupon rate is 1.55% + 0.65% = 2.20%.

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Investors who believe that interest rates will rise most likely prefer to invest
in:
A. inverse floaters.
B. fixed-rate bonds.
C. floating-rate notes.

C is correct. In contrast to fixed-rate bonds that decline in value in a rising interest rate
environment, floating-rate notes (FRNs) are less affected when interest rates increase because
their coupon rates vary with market interest rates and are reset at regular, short-term intervals.
Consequently, FRNs are favored by investors who believe that interest rates will rise.
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If interest rates are expected to increase, the coupon payment structure most
likely to benefit the issuer is a:
A. step-up coupon.
B. inflation-linked coupon.
C. cap in a floating-rate note.

C is correct. A cap in a floating-rate note (capped FRN) prevents the coupon rate
from increasing above a specified maximum rate. This feature benefits the issuer
in a rising interest rate environment because it sets a limit to the interest rate paid
on the debt.
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A 10-year, capital-indexed bond linked to the Consumer Price Index (CPI) is issued with a
coupon rate of 6% and a par value of 1,000. The bond pays interest semi-annually. During
the first six months after the bond’s issuance, the CPI increases by 2%. On the first coupon
payment date, the bond’s:
A. coupon rate increases to 8%.
B. coupon payment is equal to 40.
C. principal amount increases to 1,020.
C is correct. Capital-indexed bonds pay a fixed coupon rate that is applied to a principal amount that
increases in line with increases in the index during the bond’s life. If the consumer price index
increases by 2%, the coupon rate remains unchanged at 6%, but the principal amount increases by
2% and the coupon payment is based on the inflation-adjusted principal amount. On the first coupon
payment date, the inflation-adjusted principal amount is 1,000 × (1 + 0.02) = 1,020 and the semi-
annual coupon payment is equal to (0.06 × 1,020) ÷ 2 = 30.60.
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LOS 50.f: Describe contingency provisions affecting the timing and/or
nature of cash flows of fixed-income securities and identify whether such
provisions benefit the borrower or the lender.
Embedded options
Call options
Put options
Conversion options

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The provision that provides bondholders the right to sell the bond back to the
issuer at a predetermined price prior to the bond’s maturity date is referred to
as:
A. a put provision.
B. a make-whole call provision.
C. an original issue discount provision.

A is correct. A put provision provides bondholders the right to sell the bond back
to the issuer at a predetermined price prior to the bond’s maturity date.

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Which of the following provisions is a benefit to the issuer?
A. Put provision
B. Call provision
C. Conversion provision

B is correct. A call provision (callable bond) gives the issuer the right to redeem all or part of the
bond before the specified maturity date. If market interest rates decline or the issuer’s credit
quality improves, the issuer of a callable bond can redeem it and replace it by a cheaper bond.
Thus, the call provision is beneficial to the issuer.
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Relative to an otherwise similar option-free bond, a:
A. putable bond will trade at a higher price.
B. callable bond will trade at a higher price.
C. convertible bond will trade at a lower price.

A is correct. A put feature is beneficial to the bondholders. Thus, the price of a

putable bond will typically be higher than the price of an otherwise similar non-
putable bond.

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Investors seeking some general protection against a poor economy are most
likely to select a:
A. deferred coupon bond.
B. credit-linked coupon bond.
C. payment-in-kind coupon bond.

B is correct. A credit-linked coupon bond has a coupon that changes when the bond’s credit
rating changes. Because credit ratings tend to decline the most during recessions, credit-
linked coupon bonds may thus provide some general protection against a poor economy by
offering increased coupon payments when credit ratings decline.
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The benefit to the issuer of a deferred coupon bond is most likely related to:
A. tax management.
B. cash flow management.
C. original issue discount price.

B is correct. Deferred coupon bonds pay no coupon for their first few years but then pay higher
coupons than they otherwise normally would for the remainder of their life. Deferred coupon bonds
are common in project financing when the assets being developed may not generate any income
during the development phase, thus not providing cash flows to make interest payments. A deferred
coupon bond allows the issuer to delay interest payments until the project is completed and the cash
flows generated by the assets can be used to service the debt.

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Which of the following bond types provides the most benefit to a
bondholder when bond prices are declining?
A. Callable
B. Plain vanilla
C. Multiple put

C is correct. A putable bond is beneficial for the bondholder by guaranteeing a prespecified selling
price at the redemption date, thus offering protection when interest rates rise and bond prices
decline. Relative to a one-time put bond that incorporates a single sellback opportunity, a multiple
put bond offers more frequent sellback opportunities, thus providing the most benefit to bondholders.

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Which type of call bond option offers the greatest flexibility as to when the
issuer can exercise the option?
A. A Bermuda call
B. A European call
C. An American call

C is correct. An American call option gives the issuer the right to call the bond at
any time starting on the first call date.

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Which of the following best describes a convertible bond’s conversion
premium?
A. Bond price minus conversion value
B. Par value divided by conversion price
C. Current share price multiplied by conversion ratio

A is correct. The conversion premium is the difference between the convertible

bond’s price and its conversion value.

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Which of the following type of debt obligation most likely protects
bondholders when the assets serving as collateral are non-performing?
A. Covered bonds
B. Collateral trust bonds
C. Mortgage-backed securities

A is correct. A covered bond is a debt obligation backed by a segregated pool of

assets called a “cover pool.” When the assets that are included in the cover pool
become non-performing (i.e., the assets are not generating the promised cash
flows), the issuer must replace them with performing assets.
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A 10-year bond was issued four years ago. The bond is denominated in US
dollars, offers a coupon rate of 10% with interest paid semi-annually, and is
currently priced at 102% of par. The bond’s:
A. tenor is six years.
B. nominal rate is 5%.
C. redemption value is 102% of the par value.
A is correct. The tenor of the bond is the time remaining until the bond’s maturity date. Although the
bond had a maturity of 10 years at issuance (original maturity), it was issued four years ago. Thus,
there are six years remaining until the maturity date.
B is incorrect because the nominal rate is the coupon rate, i.e., the interest rate that the issuer agrees
to pay each year until the maturity date. Although interest is paid semi-annually, the nominal rate is
10%, not 5%.
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